“Never let a good crisis go to waste.” – Winston Churchill

Without missing a step, U.S. politicians have been beating the drums of war to parade their own agendas. Namely, Senate Democrats have been raising the alarm about cryptocurrencies being used to evade sanctions. The claim could not be further from the truth.

In a letter to Treasury Secretary Janet Yellen (and on social media), the lawmakers asserted that, “criminals, rogue states, and other actors may use digital assets and alternative payment platforms as a new means to hide cross-border transactions for nefarious purposes.” In other words, they are arguing that “cryptocurrencies risk undermining sanctions against Russia.”

Before addressing the issue itself, it’s worth noting that the letter to Yellen came days after officials from the U.S. Treasury Department told Politico,

[We] aren’t overly worried about crypto undermining the effort to choke off the Kremlin’s access to capital. Laundering large amounts of money through a dizzying array of digital wallets and exchanges is expensive, time-consuming and would likely be visible in the broader crypto market, given the massive investment portfolios of individuals and institutions named in the sanctions.

In fact, Cato’s Matthew Feeney addressed that very issue as well when he wrote,

An oligarch who does manage to buy cryptocurrencies on an exchange with fiat could seek to throw investigators off their trail by sending their holdings to a tumbler. But these are not without significant drawbacks, and some exchanges do not allow assets that have been through tumblers to enter their platform.

In other words, it’s likely that the panicked oligarchs will be able to do little more than lose money and isolate themselves further if they try to go this route.

There is certainly a steep learning curve involved with cryptocurrencies and decoding the associated terms. But it does not take a full-scale investigation to understand the fact of the matter: Cryptocurrencies are far from the “get out of jail free” card that opportunists are making them out to be.

How Sanctions Affect Cryptocurrencies

For anyone still unconvinced, it might be helpful to dig a bit deeper into how the sanctions work and how they affect the crypto-economy.

Sanctions are often spoken of as if they are sweeping bans across an entire country, but the reality is a little more nuanced than that. Currently, the sanctions that have been set forth are targeted on specific Russian individuals and companies, not the entirety of Russia’s 144 million people. (Though they may be limited in terms of direct targets, it is important to note that the sanctions do in fact affect Russia’s citizens broadly as the economy continues to collapse.)

The data does show that Russians have been rushing to buy cryptocurrencies, but it seems much more likely that this activity is based on the millions of ordinary citizens that are desperately trying to preserve their wealth. As the following chart shows, the trading volume between the ruble and bitcoin hit a nine-month high at nearly 1.5 million rubles. Yet that is equal to just 13,911 dollars––which is clearly not a Russian billionaire moving all of their money.

As for the handful of specific targets being sanctioned, moving from rubles to cryptocurrencies really won’t help them in the end. The sanctions make it illegal for U.S. citizens and companies to transact with those on the sanctions list. As Jake Chervinsky noted, “It doesn’t matter if they use dollars, gold, sea shells, or bitcoin.” It is still illegal.

Russian politicians and billionaires are welcome to try to use cryptocurrencies, but a transparent, public ledger that cannot be edited is a recipe for disaster for any criminal trying to hide their money. U.S. Attorney General Merrick Garland said, “We will leave no stone unturned in our efforts to investigate, arrest and prosecute those whose criminal acts enable the Russian government to continue this unjust war.” Cryptocurrencies may offer ordinary citizens the opportunity to escape the falling ruble, but those being sanctioned are in for a harsh reality check if they choose to use cryptocurrencies and leave an immutable paper trail on the blockchain. Such evidence is just what Garland and his fellow prosecutors need.

If lawmakers want to take away a lesson from cryptocurrencies during this war, let it be that the adoption of cryptocurrencies has brought on a system that can simultaneously undermine the bad guys, help people in need, and raise more than $28 million for the Ukrainian government during this time of crisis. Politicians should be singing cryptocurrency’s praises rather than demagoguing it.

Last week, Currency Research held its inaugural Digital Currency Conference in Washington, D.C. The event brought together experts, policymakers, technologists, central bankers, and stakeholders to discuss the future of digital currencies––namely, central bank digital currencies (CBDCs). It covered everything from quantum computing to the digital divide in payments.

While the event led to too many discussions to list in one sitting, here are three of the key takeaways that seemed to echo throughout the day.

A CBDC Is a Solution in Search of a Problem

The most pressing question of all was whether a CBDC was a “shiny new toy” for central bankers or the next great step forward in the history of money. It’s certainly might be a “step in history,” but the current outlook for CBDCs is far from great.

Douglas Elliott and Larissa de Lima at Oliver Wyman addressed the issue well last summer when they detailed six policy mistakes that need to be avoided when crafting CBDCs. One of the most important mistakes they describe might be the mistake of ignoring the other policy tools that are on the table. Luckily, some policymakers appear to be taking note of this warning. For example, Philip Lowe, Governor of the Reserve Bank of Australia (RBA), recently said, “The RBA is open to [the possibility of a CBDC]. To date, though, we have not seen a strong public policy case to move in this direction, especially given Australia’s efficient, fast, and convenient electronic payments system.”

The U.S. payments system is years behind that in Australia, but even here, a CBDC is not a unique solution. Not only has the private sector made great strides in speeding up payments, but the Fed itself is expected to launch a new service (FedNow) in 2023 specifically to update the payments system.

And much like with the payments system, the other issues a CBDC is purported to fix are all being addressed through more-targeted, private-sector endeavors. It’s just not clear what unique issue a CBDC will solve in practice, and how that solution would justify reinventing the dollar. And if that question can’t be answered, the United States would be better off renouncing plans to launch a CBDC.

Costs of Cryptocurrencies are “Too High”

Another common question throughout the conference was about the energy cost of cryptocurrencies like Bitcoin. Dave Mills, associate director at the Board of Governors of the Federal Reserve, noted the following: “If anything is to be a viable option, its costs need to be comparable to the existing banking system.” Mills is half right. However, with some tweaking, the statement can capture the full story:

If any cryptocurrency is to be a viable alternative to the traditional banking system, its net benefits need to be equal to or exceed those associated with the existing banking system.

In fact, Lawrence White wrote an essay this week explaining exactly that. A cost analysis may be one piece of the puzzle, but to judge the full picture, one must weigh both costs and benefits. It doesn’t matter if the item at hand is a bridge or a blockchain, a decision is only half informed if it’s solely judged by its costs.

Questions and Uncertainty

Finally, Sunayna Tuteja, chief innovation officer at the Federal Reserve, summarized the last takeaway when she said, “Just because you’ve been relevant for the last 100 years does not mean you’ll be relevant for the next 100 years.” Although the Fed may see a CBDC as a ticket to relevancy, there is still much uncertainty about how secure that ticket really is. For example, one of the greatest challenges in thinking about a CBDC is pinning down exactly which type of CBDC someone is talking about.

A CBDC can be wholesale, retail, synthetic, token-based, and the list goes on. Each variation has its own unique costs and benefits. So it’s important for central banks to nail down exactly what type of CBDC they want to pursue because it will ultimately undermine their attempt if they take a “Swiss Army knife approach” and try to blend them all together. It would be better to have a focused approach that delivers one or two benefits that improve (on net) problems in the current system than a scattered approach that does the minimum to check all the boxes.

The Fed did, after nearly a year of deliberations and postponing, outline its vision for a CBDC, but even that left many questions still unanswered. As time moves forward, the Fed will have to make some hard decisions about exactly what it wants in a CBDC if it is going to make the case to the American people. Until then, the future of a CBDC in the United States is far from certain.

For Next Time

With these takeaways in mind, it’s safe to say that Currency Research’s inaugural Digital Currency Conference set a great foundation for their future events to come.

Alex Gladstein, of the Human Rights Foundation, explained in an article last year that crypto-critics should look past their day-to-day experience “where they benefit from liberal democracy, property rights, free speech, a functioning legal system, and relatively stable reserve currencies like the dollar or pound.” Gladstein followed with an assessment of the global context at the time––making the case that while most Americans might not need cryptocurrencies, the world does.

But now, it seems that Americans don’t have to look quite as far as he originally had in mind.

As Norbert Michel, Walter Olson, and I wrote when the news first broke, the main intent of Canadian Prime Minister Justin Trudeau’s decision to invoke the Emergencies Act was to freeze the bank accounts of those involved in the trucker protests without so much as a court order.

With that one call, Trudeau made the case for cryptocurrency abundantly clear: cryptocurrencies offer a way to protect one’s wealth from authoritarian governments and that’s a consideration that needs to be made even in one of the freest countries in the world.

Two Words: Censorship Resistance

Censorship resistance is one of the most important features cryptocurrencies offer for those trapped in authoritarian regimes. Where governments can control, or censor, the public through financial institutions (i.e., a freeze on bank accounts, asset forfeiture, etc.), cryptocurrencies offer a new opportunity to protect one’s wealth.

One problem with traditional financial institutions is that they hinge on the use of third-party intermediaries, which also create a “choke point” that governments can take advantage of. For example, through the lens of the third-party doctrine, the U.S. government views ownership of a bank account to be a surrendering of one’s Fourth Amendment right to privacy when it comes to financial records.

In contrast, as noted previously, the absence of a third-party intermediary in decentralized cryptocurrencies means that there is no one for the government to pressure to release a person’s information except for the direct owner of that information. If the U.S. government were to take action against such a direct owner, it would first need to make its case and secure a court order.

A Critical Caveat: Keep Your Coins

Yet critically, cryptocurrencies are not completely immune from the third-party doctrine. In fact, because of that reality, cryptocurrency users will often mention lines like, “Not your keys, not your coins.” In short, the phrase is simply calling attention to the importance of self-hosted wallets. If you choose to trust a third party to host your wallet, then you are not gaining all of the protections that cryptocurrencies can offer.

The advent of Bitcoin, and other cryptocurrencies like it, introduced the opportunity to remove intermediaries and electronically self-host one’s money. In other words, it offered the opportunity to “be your own bank.” But that opportunity has not stopped people from using an intermediary. Kraken, Coinbase, FTX, and many others have made it easier than ever to use cryptocurrencies, but this benefit comes at a price––like traditional banks, they too are subject to the third-party doctrine.

That reality was put on full display when Jesse Powell, the CEO of Kraken, responded to the situation in Canada by candidly explaining that government orders to freeze accounts is something that has happened and likely will happen again where people use intermediaries. Powell said, “If you’re worried about it, don’t keep your funds with any centralized/​regulated custodian. We cannot protect you. Get your coins/​cash out and only trade [peer-to-peer].”

And as if the situation could not have been made worse in Canada, the Ontario Securities Commission actually reported Powell’s tweet (as well as one from the CEO of Coinbase, Brian Armstrong) to law enforcement on the grounds that he was giving instruction on how to avoid the restrictions.

Reactions like that of the Ontario Securities Commission are clear evidence of why it’s important for the United States to get ahead by establishing protections for self-hosted wallets. One such example is the protection outlined in Representative Warren Davidson’s (R‑OH) Keep Your Coins Act where, if enacted, federal agencies would be prohibited from restricting the use of cryptocurrencies in self-hosted wallets. Otherwise, it’s possible that regulators could impose impossible compliance standards and block the use of self-hosted wallets.

Central Bank Digital Currencies in Context

Trudeau’s decision, however, did not just make the case for cryptocurrencies. It also made the case against central bank digital currencies, or CBDCs.

If Canada had a CBDC available––especially on the individual or retail level––the process of freezing accounts would have been expedited and likely on a much grander scale. Again and again, proponents of CBDCs have spoken highly of the programming and surveillance possibilities for a CBDC. This degree of finite control would have directly linked the Canadian government to the protestors’ financial resources. And it will do the same in the United States if a CBDC is adopted.

In fact, in a prescient moment during an event at the Competitive Enterprise Institute on February 8, Representative Tom Emmer (R‑MN) warned that there would be little to stop “digital authoritarianism” from being used to curb protests in the states. He explained that such a risk was why he believed the Federal Reserve should be banned from issuing a CBDC at the retail level.

Zooming Out

Walter Olsen may have said it best when he wrote, “Monday’s edicts underscore how dangerous it is to arm government with the kind of financial and emergency powers that can bypass due process, bring targets to their knees through economic incapacitation without trial, and shred privacy.” Whether you were for the convoy or not, this is a concern that everyone should share. Jake Chervinsky made that point well when he wrote, “If the politicians you like can freeze the accounts of the protesters you hate then the politicians you hate can freeze the accounts of the protesters you like. How certain are you the politicians you hate will never, ever be in power again?”

Canada has already started to unfreeze the bank accounts of protestors, but this decision is one that should not be forgotten any time soon. It’s a salient reminder of the power governments not only hold, but can use at a moment’s notice to rein in the population.

Building a bridge is costly: It takes labor and machinery and raw materials that have alternative uses. Does it follow that building it is a waste? No. Waste occurs when the cost incurred exceeds the benefit attained. Cost greater than zero does not imply cost greater than benefit. Does it follow that the bridge is worth building? No again. A bridge to nowhere might be built even though it is wasteful, if the few beneficiaries don’t bear the costs themselves. To know whether a particular bridge is worth building we need to compare benefit to cost.

To count benefits and costs, we observe market prices and transaction quantities. None of us has access to a god-like perspective. Consequently, for normal private goods where costs and benefits fall on producers and consumers, economists normally defer to the judgments of the market participants who actually bear the costs about whether the benefits of an activity exceed its costs. Buyers presumably value a good more than the price they pay, or they wouldn’t buy, and producers incur average costs that are less than that price, or they would exit the industry. In the case of Bitcoin, the electricity bills for proof of work are ultimately paid by Bitcoin users, just as costs of production for bread and milk are borne by buyers of bread and milk. Bitcoin users pay directly when they pay blockchain fees, and indirectly when new Bitcoin is awarded to miners, enlarging the stock of Bitcoin and diluting the purchasing power per unit compared to what it would have been with a constant stock.

For Bitcoin, as for other goods, a useful accounting needs to consider both costs and benefits. Proponents of Bitcoin have been known to downplay the costs, or even count them as benefits, while opponents have been known to downplay the benefits and even count them as costs.

Downplaying costs

Bitcoin proponents sometimes emphasize that Bitcoin mining operations are able to locate wherever electricity can be produced at least cost, such as natural gas fields where excess gas would otherwise be burned off, or remote hydroelectric plants with few alternative consumers (Goyal 2021). And Bitcoin miners plugged into a regular electricity grid will shut down quickly to free electricity for other users during times of peak load that push the price per kilowatt-hour above the miners’ break-even point. These abilities reduce the opportunity cost of Bitcoin’s electricity use compared to the counterfactual of using only high-cost electricity. But it does not make the cost zero or turn it into a benefit.

Proponents applaud the fact that the Bitcoin mining industry draws a higher proportion of its electricity from renewable or sustainable or non-polluting sources than other industries. But using electricity from those sources of electricity is still a cost and not a benefit of Bitcoin. Green energy is still costly-to-generate energy.

When Bitcoin mining helps to finance expenditure on materials and labor to build new electricity generating facilities, or on repairs and maintenance crews to bring old facilities back into operation (Murillo 2022), that is not a benefit that Bitcoin provides by comparison to cryptoassets that use less energy. It is a cost. Building or refitting power plants is a costly use of labor and material resources, even if the new facilities burn no fossil fuel and emit no carbon.

Downplaying benefits

European Central Bank economists Ulrich Bindseil, Patrick Papsdorf, and Jürgen Schaaf (hereafter BPS) (2022, p. 4), labeling Bitcoin an “encrypted threat,” have written that because “the Bitcoin network comes with a large energy hunger due to its reliance on proof-of-work” it therefore “wastes power.” But it is a non sequitur to leap to that conclusion without considering its benefits. It doesn’t follow even when stated in a comparative fashion, as when they suggest that Bitcoin is wasteful because the proof-of-work method of processing transactions uses more energy per transaction than alternative methods like proof-of-stake or like the status quo banking system. To avoid rushing prematurely to judgments like these we need to consider the benefits that can be attributed to the proof-of-work protocol. To say that the proof-of-work method is wasteful simply because it uses more energy is to suppose that it provides zero benefits (no greater privacy, no greater security, no greater credibility of the release schedule) over a payment system run by proof-of-stake or on a single central ledger. But the assumption of zero benefits is inconsistent with the observation that some users prefer proof-of-work systems.

The default presumption of modern Paretian welfare economics is that under the force of free competition the market for a private good like Bitcoin (or any other cryptoasset) operates efficiently. Mutual gains from trade are found and realized. To rebut that presumption, a benevolent would-be increaser of net social benefits needs to meet a burden of proof. To warrant restrictions on mutually beneficial trades, evidence is necessary to show that Bitcoin production is harming third parties in ways that violate their property rights or, as BPS (p. 2) have put it, that Bitcoin imposes significant negative externalities.

The fact that the Bitcoin network uses electricity does not provide the requisite evidence. Hospitals use electricity, as do school buses and airplanes. Virtually every industry uses electricity to produce its output. Bitcoin is not exceptional in that regard. It is true that, at the margin, Bitcoin’s demand for electricity contributes to total demand and thereby to determining the price of electricity. The greater is Bitcoin’s electricity use, the higher is the price of electricity. But that, too, is equally true for every other electric-power-using industry. The spillover effect of additional electricity demand on the price of electricity is, in technical economic terms, merely a pecuniary externality, not a technological externality. As such, it is not a source of inefficiency. Price changes are necessary for any market to regain efficiency in the face of supply or demand shifts. Price changes do not interfere with anyone’s use and enjoyment of his property. They are not the kind of Pareto-relevant externality we should worry about.

An understandable concern about electricity use, from any industry, is that additional electricity generation generates significant negative externalities in the form of additional carbon dioxide and other emissions. BPS ask whether negative externalities of energy consumption “are really priced in through adequate taxes.” The remedy for carbon pollution that the authors suggest is a tax on carbon emissions. If it were known what the economic costs of marginal carbon emissions are, then an appropriately sized tax on carbon would internalize the externality by bringing the costs to bear on energy producers.[1] But note that the tax envisioned would be a tax on electricity producers according to their carbon emissions. It would not be a tax on, and certainly not a case for banning or restricting, any particular energy-using activity. Because the appropriate level of a carbon tax is orthogonal to the mix of energy uses, it has nothing to do with Bitcoin as such.

To allow the economy to produce the highest-valued mix of outputs, we must allow producers who have the highest-valued uses for electricity resources (that is, turn a marginal dollar’s‑worth of electricity into the outputs for which consumers are willing to pay the most) bid them away from others.

Critics who declare that Bitcoin is “worthless,” despite users’ willingness to pay for it, signal that they disregard consumers’ valuations, and arbitrarily invoke their own personal valuations—just as they would if they declared that hospitals, school buses, or airplanes are worthless. Sometimes the invocation of the critic’s personal preferences is clear, as for example in the argument that there are no social benefits to offset its costs, only transfers, because Bitcoin is merely a “gambling game.” Absent fraud, people who freely choose to gamble at casinos or participate in lotteries benefit in their own estimation in the sense that they chose gambling over other forms of entertainment. Likewise Bitcoin gamblers.

Of course, many Bitcoin investors don’t think that the odds of coming out ahead are stacked against them the way like the odds in casino games and lotteries, but on the contrary are in their favor. Their risk-taking attitude is like that of an optimistic investor who thinks that a particular stock is likely to outperform the market. They think that there’s a good chance that the purchasing power of Bitcoin will continue to rise as the (hoped-for) medium-of-exchange use of Bitcoin spreads, perhaps to the point of Bitcoin becoming the world’s dominant currency. They may be overestimating the likelihood of that outcome (my own view is that the volatility of Bitcoin’s purchasing power makes its widespread use as a medium of exchange very unlikely), but in a free economy we leave such risk-taking to the investors who bear the gains and losses.

At the pessimistic end of the spectrum, BPS (p. 2) forecast that the use and the price of Bitcoin will collapse, and that as a result “the net welfare effects of Bitcoin over its life cycle will have been significantly negative.” Their forecast clearly clashes with the forecasts of Bitcoin holders, not to mention the forecasts of venture capitalists and entrepreneurs who are investing large sums in ancillary products to facilitate Bitcoin use. None of us yet knows what the future transaction use and price will be. Meanwhile, the Efficient Markets Hypothesis suggests that the best point estimate of the discounted future price of Bitcoin is the current price.

BPS (pp. 9–10) worry not only about Bitcoin’s “risks and costs for invested individuals,” but also its risks and costs for “the society at large.” Noting that the Bitcoin project may fail, they write:

If it were true that Bitcoin is eventually unsustainable and will not persist, and will not have generated value for society apart from temporary hopes of speculative gains which eventually are disappointed, then these private costs will however have represented a net loss for society.

In the event that the value of Bitcoin goes to zero, investors would give back the gains they enjoyed during Bitcoin’s rise from zero to its peak. The episode would represent a net loss for society in the sense that the costs of labor and machines and electricity used would not be offset by any gain to third parties. But this is true of every investment project on earth. The failure of any particular firm, or even an industry, wiping out the equity of shareholders and the value of some specific physical and human capital, does not abridge property rights or impoverish those who avoided investing in or working for it. In a free economy, we therefore let entrepreneurs take risks. In cases where they succeed, by the same logic, the gains are net social gains. Society as a whole benefits from the superior economic growth of an economic system where entrepreneurs are free to innovate and free to fail.

By the way, to say that Bitcoin “will not have generated value for society apart from temporary hopes of speculative gains” is to ignore the fact that Bitcoin is not just a gambling game. It generates value in a second way, by providing an alternative payment rail for transactions or donations that need to route around a censorious central bank to reach government-disfavored recipients. To view such transactions as problematic, as a cost rather than a benefit, would be to view things like a state advocate rather than like a consumer advocate.

*******

[1] For the argument that correct price tags for technological externalities are inherently unknowable, because (lacking excludability) individual consumers do not reveal their willingness to pay for remediation, see White (2012, pp. 353–353).


[Cross-posted from Alt‑M.org]

Prime Minister Justin Trudeau resorted to invoking the Emergencies Act for the first time in Canadian history to try to control the protests over COVID-19 restrictions. Most notably among Trudeau’s response was the decision to freeze bank accounts of protestors and expand the reach of anti-money laundering (AML) laws.

Although taking people’s money away, even if temporarily, surely limits their ability to legally protest, Trudeau carefully defended his decision by stating,

We’re not suspending fundamental rights or overriding [Canada’s] Charter of Rights and Freedoms. We are not limiting people’s freedom of speech. We are not limiting freedom of peaceful assembly. We are not preventing people from exercising their right to protest legally. We are reinforcing the principles, values, and institutions that keep all Canadians free.

Regardless of what Trudeau says about his government’s actions, Deputy Prime Minister and Finance Minister Chrystia Freeland’s remarks demonstrate just how far these policies go:

In invoking the Emergencies Act, we are … broadening the scope of Canada’s anti-money laundering and terrorist financing rules so that they cover crowdfunding platforms and the payments service providers they use. These changes cover all forms of transactions––including digital assets such as cryptocurrencies… As of today, a bank or other financial service provider will be able to immediately freeze or suspend an account without a court order.

Many Americans may not realize it, but the same principles that make this attack on Canadians’ financial freedom possible are engrained in U.S. law. Specifically, they are featured in both the Bank Secrecy Act and the ever-expanding use of the third-party doctrine. However, a notable step in the right direction came today with the announcement of Representative Warren Davidson’s (R‑OH) Keep Your Coins Act.

Those familiar with monetary and financial policy will undoubtedly recognize the clever play on “KYC” (or, know your customer), but the focus of Representative Davidson’s bill is on protecting self-hosted wallets from unwarranted prohibition or restriction.

Holding cryptocurrency in a “self-hosted” wallet is merely the digital equivalent of holding physical cash in a traditional wallet. It gives the owner complete control over what’s held inside it and the extent that they want to maintain their privacy. Representative Davidson is right to point out the same cannot be said of cryptocurrencies held in wallets or accounts maintained by third parties because, in the eyes of the federal government, relying on such third parties effectively waives an individual’s right to financial privacy.

So, while financial privacy should already be protected by the Constitution (namely, the Fourth Amendment), preventing the government from being able to prohibit or restrict the use of self-hosted wallets is a much-needed policy improvement. And it seems that it’s a step forward that is needed now more than ever.

When considering what cryptocurrencies mean for liberty, cases when authoritarian regimes freeze the bank accounts of activists and rivals serve as stark reminders of how little regard for individuals such governments have. Sadly, Trudeau’s decision demonstrates that this kind of oppressive behavior is not unique to authoritarian governments.

Whether people realize it or not, this sort of event could just as easily occur in the United States. In fact, it’s a prime example of why Americans need stronger financial privacy rights.

A Wall Street Journal editorial (“Inflation Haunts the Biden Economy”), fears that “one risk is the Fed gets spooked by the market reaction to its tightening.” However, the stock market is rarely hyper-sensitive to Fed statements or actions for more than a few days.

“Stocks Turn Lower After Fed Announcement” was the Journal’s January 26 headline, yet the Fed chairman did not actually announce anything much different from what was already expected – namely, phasing-out the “Quantitative Easing” routine plus several quarter-point increases in the IORB (Interest on Reserve Balances) and the more familiar federal funds rate.

Nobody was betting on an easier Fed policy after January 27, yet the S&P 500 nonetheless rose by another 4.2% by the time the market opened uneasily on February 11 following a surprisingly bad CPI report that led many to speculate about an imminent half-point rise in the fed funds rate. Why? Probably because COVID-19 infections were down, and earnings were up. The Fed cannot easily trump good news.

We have seen this show before, but it rarely has a happy conclusion. Most recently, the Fed raised the fed funds rate in nine little steps from 0.08% in November 2015 to 2.4% in December 2018 and kept it there through July 2019. The first 5 or 6 hikes in the fed funds rate in 2016–18 had no sustained impact on the upward trajectory of stock prices.

As the first graph shows, the black line for the S&P 500 kept rising until the final two increases in short-term rates, when the fed funds rate rose above 1.9% and the 10-year bond briefly topped 3% before falling quickly

Although stock market averages appeared initially unperturbed by the 2016–19 notching-up of the fed funds rate, the market can react negatively to bond yields if (1) higher yields reduce the price-earnings multiple for stocks, but also if (2) long-term bond yields rise very little as the Fed pushes short-term rates higher, thus flattening the yield curve.

The price-earnings multiple is affected by large changes in long-term interest rates because a higher rate reduces the discounted present value of expected (but uncertain) future earnings. But raising the fed funds rate does not necessarily raise bond yields and may sometimes lower them by creating expectations of slower income growth (as in 2019) thus inverting the yield curve shown as a black line in the second group.

As the Journal editorial emphasized, the Fed needs to stop buying more Treasury debts and start rolling back its bloated balance sheet. This may not prove as troublesome as paying escalating interest rates on bank reserves (IORB). Thomas Hogan points out that the Fed’s massive asset purchases had no visible impact on bank lending which “remains below the level of the pre-crisis trend.”

What does affect bank lending, however, is the yield curve – shown as a black line in the second graph with the fed funds rate in red. Past increases in the fed funds rate have succeeded in pushing short-term rates (the 3‑month T‑bill in this case) above the 10-year bond yield. Since banks make money by borrowing short and lending long, an inverted yield curve is a well-known leading indicator of recession as well as stock market crashes.

During the last major spike in oil prices and inflation (“The Great Recession”) the Fed engaged in massive Quantitative Tightening(QT): Federal Reserve Bank holdings of Treasury debt were deliberately reduced from $790.5 billion in the second quarter of 2007 to $478.2 billion in the second quarter of 2008, as the price of Texas crude oil nearly tripled from $50 to $145 a barrel. What did all that QT do to yields on 10-year bonds? They fell – from 5% in early July 2007 to 4% a year later.

The experiment with quantitative tightening was soon followed by three tests of Quantitative Easing (QE) which, I recently noted, were not nearly as successful in lowering bond yields as QT had been. “During QE1 ($1.5 trillion) the 10-year Treasury yield rose from 2.97% on March 16 to 3.84% on March 31, 2010, then fell after QE1 ended. During QE2 ($827 billion) the 10-year yield fell from 2.67% on November 3, 2010 to 1.67% by June 29, 2012, but yields dipped even lower for months after it ended. Under QE3, yields rose from 1.86% at the start of 2013 to 3.04% by the end of the year, but then fell steadily to 2.34% by the end of the famous ‘taper’ in October 2014 and continued falling after that.”

In the past two years, the Fed’s portfolio further exploded to $8.9 trillion, but that cannot begin to explain the gyrations in U.S. bond yields in the first graph nor the collapse of global bond yields when the pandemic shut down much of the world economy.

The stock market is not nearly as sensitive to the Fed-managed overnight interest rates as many assume, nor are bond market yields or bank lending so clearly affected by quantitative easing on tightening. Unless the Fed bungles into crushing finance and the economy by inverting the yield curve, which does not seem an imminent threat, stocks in U.S. companies are still the best place to seek long-term returns.

It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.

Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed’s balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.

Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.

Andolfatto writes that the Fed’s “rate of return has generally followed the path of market interest rates downward.” While that was true in 2007-08, it should be noted that the Fed’s rate of return largely stopped following the downward path of market interest after 2008. As market rates on five-year Treasuries fell closer to the administered interest rate on reserves after 2008, the Fed shifted from a portfolio maturity of 5 years to one of around 12 years, as if determined to keep its interest income large. This is shown in the following two figures from a 2016 Cato Journal article of mine.

Here is Andolfatto’s closing pitch for embracing the status quo: “Reducing the Fed’s balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. … if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?” The Fed faces an “arbitrage opportunity.” Having the Fed hold Treasury debt, in place of the public holding it, yields a pure arbitrage profit, because the Fed can borrow to carry the debt at a rate lower than the rate at which the Treasury borrows.

Characterizing the situation this way, however, neglects the simple difference between borrowing short and borrowing long. When the Fed borrows short from the banks to lend long to the Treasury, it does not do so costlessly. Duration transformation carries a risk of capital loss, also known as duration risk. Suppose the yield curve shifts up, both short and long interest rates rising together. The Fed will experience a decline in present value of its assets that will swamp the smaller decline in the present value of its liabilities. Such an event is not unknown: in 1979–81 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2‑year deposits. In cash-flow terms, such an event would mean that the Fed would quickly have to start paying higher interest rates to borrow, while its asset portfolio continues to pay low yields and roll over much more slowly. The Fed’s annual net transfer to the Treasury might even go negative. Smaller or negative transfers from the Fed to the Treasury would mean a sudden jump in the present value of the public’s ordinary tax liabilities. Net interest income from playing the yield curve is not a free lunch.

The Fed has also been carrying significant default risk by holding $1.7 trillion of its portfolio not in Treasuries but in mortgage-backed securities. It was not so many years ago that MBS were trading well below par because of their default risk. Indeed it was to push their prices back towards par that the Fed purchased so many.

Responding to a commentator on his blog who pointed out the Fed’s duration risk, Andolfatto remarks: “the duration risk … could be mitigated considerably if the Fed restricted itself to short-duration assets.” He proposes that “If a one-year UST is yielding anything significantly higher than the interest on Fed liabilities, then the Fed can make a profit for the government.” But when we look at the actual numbers, we find that the yield on one-year UST is not significantly higher. The Fed could not in fact continue to make a profit for the government. One-year Treasuries are currently yielding just 82 basis points (0.82%), only 7 basis points more than the 75 basis points that the Fed pays on reserves. Multiplying 7 basis points by the Fed’s $4.45 trillion asset portfolio yields only $3.1 billion in net interest income, less than the Fed’s 2016 budget of $4.5 billion or its ex-post 2015 operating expenses of $4.2 billion. Mitigating the duration risk by going to a portfolio of one-year Treasuries would thus eliminate the Fed’s profit from borrowing from banks and relending to the Treasury.

The principal cases for normalizing the Fed’s balance sheet are (1) the Fed should not distort the allocation of credit by holding trillions in MBS, and (2) normalizing the size of the balance sheet would allow the Fed to normalize the conduct of monetary policy by making bank reserves scarce again. There is no fiscal-free-lunch case for holding off on normalization.